Subchapter S Corporation Losses Limited by Tax Basis

One of the benefits of Subchapter S corporations is the ability to have losses flow through from the business’ tax return to the individual shareholder’s tax return. These flow-through losses are limited by the shareholder’s tax basis in the S corporation stock. The court recently addressed this limitation in Tinsley v. Commissioner, T.C. Summary Opinion 2017-9. This case is timely given that this issue is the focus of the IRS’s new audit campaigns.

The taxpayer in Tinsley was the sole shareholder of an S corporation. The corporation had borrowed approximately $100,000 from a bank. The S corporation then dissolved under state law and reported a loss on its 1120S tax return. The bank then renewed the loan, but it listed the old corporation as the borrower. It also had the taxpayer guarantee the loan. The taxpayer continued to operate the business under the old name. The taxpayer reported the loss on his personal tax returns. The IRS disallowed the flow-through loss.

The taxpayer did not have any tax basis in the S corporation stock due to capital contributions to the business. He argued that he had tax basis in the S corporation stock given his personal guarantee of the $100,000 bank loan:

he contends that upon the liquidation, he assumed the balance due on the note as guarantor, and because he was the sole remaining obligor, this assumption was a contribution to capital, allowing him to deduct the amount of Command Computers’ losses. Further, Mr. Tinsley asserts that following Command Computers’ liquidation, the Bank expected him, as guarantor, to repay the loan and that the Bank’s expectation was sufficient to generate a basis for Mr. Tinsley in Command Computers.

The court did not agree. The court noted that merely guaranteeing an S corporation’s debt is not sufficient to generate a basis under section 1366(d). The court noted that a shareholder may obtain an increase in basis in an S corporation only if there is an economic outlay on the part of the shareholder that leaves him or her “poorer in a material sense.” The taxpayer has to have an economic outlay. This can come about if the lender looks primarily to the taxpayer to repay the loan.

According to the court, there was no evidence that the lender in this case looked only to the taxpayer to repay the loan. The court seems to say that the lender looks to the non-existent corporation that is listed as the borrower. The court also said there was no evidence of an economic outlay by the taxpayer as the court record did not include evidence that the taxpayer was the party paying the loan.

These 1366(d) basis rules are in addition to the Sec. 465 at-risk and Sec. 469 passive activity loss rules. It should also be noted that this same fact pattern would satisfy the Sec. 465 at-risk rules as they do not require an economic outlay or the taxpayer to be the primary source of repayment.

To avoid this type of Sec. 1366(d) tax basis issue, taxpayers should document their economic outlays and/or that the borrower looks primarily to them to satisfy the loan.

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